In case you missed it: Part 1 – Part 2 – Part 3 – Part 4

Operations
The second reason to spend money is on operations. These are called fixed costs by accountants and they are the costs that stay the same from month to month just to keep the lights on and the doors open. Rent, utilities, marketing and advertising costs, taxes and labor that is not COGS go in this category.

There are two keys to operations costs. The first is sales volume. Very often people get seduced into starting a consulting business of some sort by not considering sales volume. They see that if they sell their skill at graphic design, or wedding planning, or computer programming or some such they can get $100 per hour. Their COGS is close to zero and working out of their home, so is overhead. Except for their salary. But if they only sell a couple hours a month their sales volume won’t cover much, even at a high hourly rate. At the other extreme, Starbucks sells coffee for about $3. Even though their COGS is pretty low, it doesn’t leave much from a $3 sale. But they sell so many that it covers the rent, and the green aprons and the comfy chairs.

So no mater how high your gross profit is, if you can’t sell enough volume to cover your overhead you’re sunk. One problem start-ups have is estimating how long it will take to ramp up their sales volume high enough.

The other key to controlling operations costs is chunking. You want to keep these costs as low as possible. But operations buys you capacity, and you can’t serve your customers without capacity. Every time Kinko’s gets a new copy machine, its capacity to sell copies goes up. Paper and toner are COGS, but the cost of the machine is the same whether anyone uses it or not. So their operational costs increase or decrease in “chunks” the size of a copy machine.

You can think of operations cost and the capacity it buys like a stair step. They stay constant for a while till you “chunk” up to the next step. (COGS on the other hand is like a roller coaster – constantly moving up or down with sales).

The trick is to run close to the top of your chunk. The most profitable companies are ones who are close to maxing out their capacity because their operational costs are low compared to their sales volume.

Takeaways:

• No matter how high your profit margin is, if your sales volume isn’t enough to cover your fixed costs, you’ll run out of cash.
• Operations costs buy you capacity. Try to run as close to maxing out your capacity as you can – that allows the greatest amount of your sales volume to flow through to the bottom line.
• In other words, don’t buy more capacity than you can use to serve customers.